A Redeeming Interest in Religious Freedom: Are Islamic Mortgage Alternatives Clogs on the Right of Redemption?
Fordham Journal of Corporate & Financial Law
Copyright c 2008 by the authors. Fordham Journal of Corporate & Financial Law is produced
by The Berkeley Electronic Press (bepress). http://ir.lawnet.fordham.edu/jcfl
A REDEEMING INTEREST IN RELIGIOUS
FREEDOM: ARE ISLAMIC MORTGAGE
ALTERNATIVES CLOGS ON THE EQUITABLE
RIGHT OF REDEMPTION?
*Law clerk to the Honorable William M. Barker, Chief Justice of the Tennessee
Supreme Court; J.D., The University of Tennessee College of Law, 2007; B.B.A.,
Accounting, Middle Tennessee State University, 2003. I extend my many thanks to
Professor Gregory M. Stein for his insightful comments and guidance. In addition, I am
sincerely grateful to Clyde E. Willis and my parents for their relentless encouragement
to think outside the box.
While the American dream is as varied as the people that comprise
this nation, many would agree that one of the pillars of that dream is
home ownership. In light of the Qur’an’s prohibition against paying
interest,1 homeownership remains nothing more than a dream for many
Muslims living in America. This Article explores how a Muslim in
America can purchase a home with mortgage alternatives specifically
tailored to meet his needs, and how these mortgage alternatives can be
executed to avoid becoming a clog on the equitable right of redemption.
While these mortgage alternatives are not without critics, courts and
regulatory agencies should nevertheless encourage their development
because: (1) the Islamic mortgagor’s equitable right of redemption is
protected, either through contract rights or through the functional
equivalent to mortgages; and (2) on balance, these mortgage alternatives
help a growing segment of the population realize the American dream.
To fully explore this issue, Part I of this Article begins with a
thorough discussion of the equitable right of redemption, why
mortgagees cannot clog that right, and how the courts of equity
determine if that right should be given to a borrower. Part II explores
the reasons why Muslims face difficulties in the housing market and
how lending institutions are responding to meet the needs of these
particular consumers. Part II also details two proposed types of
mortgage alternatives available to Muslims, the regulatory responses to
them, and addresses challenges from critics. Part III applies a two-step
analysis to determine whether the proposed alternatives are equitable
mortgages and, if so, whether they clog the borrower’s equity of
redemption. Lastly, Part IV highlights appropriate means to ameliorate
the dangers these alternatives may pose and the benefits these
alternatives offer to Islamic mortgagors.
I. THE EQUITABLE RIGHT OF REDEMPTION
The mortgage, which originated in fourteenth century England,2
commonly consisted of a borrower (“mortgagor”) giving a deed in fee
1. Qur’an 2:275; see also infra text accompanying notes 58-62.
2. JESSE DUKEMINIER & JAMES E. KRIER, PROPERTY 645 (5th ed. 2002); see also
C.C. Williams, Clogging the Equity of Redemption, 40 W. VA. L.Q. 31, 32 (1933).
simple to a lender (“mortgagee”), with a condition subsequent provision
(“defeasance clause”) stipulating that if the mortgagor repaid the debt on
the given due date (“law day”), the deed would defease and the title
would revert back to the mortgagor.3 Under the mortgage, the
mortgagee was entitled to possession of the real property and he could
collect any rents and apply them to the debt.4 Ironically, the reason for
the mortgagee’s entitlement to rents was the Church’s prohibition on
paying interest during this period.5 The harsh reality of the time was
that if the mortgagor failed to repay the debt on law day, then the
mortgagee would own the real property in fee simple absolute and the
defeasance clause would no longer be valid.6 Since the land was
generally worth more than the debt, the mortgagee received a windfall.7
In response to the mortgagee’s perceived unjust enrichment,
mortgagors began to petition the chancery courts to use its equitable
powers to permit delinquent mortgagors another opportunity to pay the
debt and reclaim their real property.8 The chancellors responded by
finding “that prompt payment was not of sufficient importance to justify
the debtor losing the property when the lender could be compensated by
an award of money . . .”9 and, therefore, created the equitable right of
redemption to cure this disparate inequity.10 While initially the
chancellors only allowed for redemption to prevent “great injustice[s],”
by the seventeenth century the equitable right of redemption was well
3. See DUKEMINIER & KRIER, supra note 2, at 645; see also RESTATEMENT
(THIRD) OF PROPERTY: MORTGAGES § 3.1 cmt. a (1997); Ann M. Burkhart, Freeing
Mortgages of Merger, 40 VAND. L. REV. 283, 322-29 (1987).
4. Lou J. Viverito, Comment, The Shared Appreciation Mortgage: A Clog on the
Equity of Redemption?, 15 J. MARSHALL L. REV. 131, 144 (1982) (citing ROBERT
KRAVTOVIL, MODERN MORTGAGE LAW AND PRACTICE 24 (1972)).
5. For the Biblical prohibitions against paying interest, see Deuteronomy 23:19-20
(stating, “Thou shalt not lend upon usury to thy brother; . . . Unto a stranger thou
mayest lend upon usury; but unto thy brother thou shalt not lend upon usury”); Exodus
22:25 (noting, “If you lend money to my people, to the poor among you, you are not to
act as a creditor to him; you shall not charge him”); Leviticus 25:35 (commanding, “Do
not take usurious interest from him, but revere your God, that your countryman may
live with you. You shall not give him your silver at interest”); Luke 6:35 (admonishing
Christians, “Lend freely, hoping nothing thereby”).
6. See DUKEMINIER & KRIER, supra note 2, at 645.
10. See Viverito, supra note 4, at 145.
established as a matter of course and right.11 As a result of this new
equitable right, the delinquent mortgagor was permitted to sue in equity
to redeem his property.12 Upon payment of the debt with interest, the
chancellor would compel the mortgagee to convey the land to the
Naturally, the mortgagee did not react favorably to the birth of
these new debtor-protection rights.14 Under the new protection scheme,
the mortgagee remained in danger of losing the real property even after
the mortgagor’s default.15 Once again, acting in equity, the chancellors
promulgated a second new right: strict foreclosure and, later, the
foreclosure sale.16 Under the right of strict foreclosure, the mortgagee
could petition the chancery court to extinguish the mortgagor’s equitable
right of redemption, thereby assuring the mortgagee that his real
property would not be redeemed at some later date.17 Once the
chancellor granted the strict foreclosure, the mortgagor was ordered to
pay the debt within a specific time frame or suffer the loss of the
property forever.18 As new equitable rights evolved, the chancellors
created the judicial foreclosure sale whereby the court held a public sale
to dispose of the real property.19 Under the terms of the judicial
foreclosure sale, the court paid the mortgagee from the sale proceeds to
extinguish the outstanding mortgage debt and then remitted any excess
to the mortgagor.20 If the foreclosure property failed to sell for an
adequate amount to extinguish the mortgage debt, the mortgagee could
sue the mortgagor for the deficiency.21
While strict foreclosure and the foreclosure sale brought some
finality to the mortgagee, it was a costly endeavor.22 In order to
circumvent the equity courts and to take advantage of their superior
bargaining position, mortgagees began inserting waiver clauses whereby
the mortgagor agreed to forego his redemption rights.23 The chancery
courts refused to enforce these clauses, however, holding that the
equitable right of redemption could not be waived.24 The first use of
“clog” to describe the mortgagees’ actions is found in Bacon v. Bacon
from 1639, “where the mortgagee will suddenly bestow unnecessary
costs upon the mortgaged lands, of purposes to clogg [sic] the lands, to
prevent the mortgagor’s redemption . . . .”25 Thus, over time, the
clogging principle established itself in the common law, ultimately
migrating to the American colonies where it enjoys the same
The most recent version of the Restatement of Property describes
the equity of redemption as “[f]rom the time the full obligation secured
by a mortgage becomes due and payable until the mortgage is
foreclosed, a mortgagor has the right to redeem the mortgaged real estate
from the encumbrance of the mortgage by tendering payment or
performance of the obligation to the mortgagee.”27 Likewise, it
incorporates the prohibition against clogging in the next subsection by
stating that “[a]ny agreement in or created contemporaneously with a
mortgage that impairs the mortgagor’s right described [in the
Restatement] is ineffective.”28
The U.S. Supreme Court highlighted similar language in the late
nineteenth century: “This right [of redemption] cannot be waived or
abandoned by any stipulation of the parties made at the time, even if
embodied in the mortgage. This is a doctrine from which a court of
equity never deviates.”29 While the Court clearly recognized the
importance of the equity of redemption, it lacked subject matter
jurisdiction over state mortgage law and only heard this controversy
because it had appellate jurisdiction in the District of Columbia at that
23. See Viverito, supra note 4, at 145.
24. Id. at 147.
25. Id. at 146 (citing Bacon v. Bacon, 21 Eng. Rep. 146 (1639)).
26. See RESTATEMENT, supra note 3.
28. See RESTATEMENT, supra note 3, § 3.1(b).
29. Peugh v. Davis, 96 U.S. 332, 337 (1877).
30. See generally United States v. Belt, 319 U.S. 521 (1943) (discussing the
jurisdiction of the U.S. Supreme Court over the District of Columbia).
For each new method mortgagees devise to emasculate the equity
of redemption, the courts of equity attempt to keep pace. In analyzing
whether a real estate financing arrangement is a clog on the equity of
redemption, the majority of the courts of equity hold to the centuries-old
maxim “once a mortgage, always a mortgage.”31 The courts generally
follow a two-step analysis under this premise.32 First, the courts of
equity ask if the arrangement creates an equitable mortgage. If the
chancellor determines that one exists, she examines whether the
arrangement clogs the mortgagor’s right to redeem the property before a
valid foreclosure.33 In answering the threshold question, the chancellors
are not bound by how the parties label the transaction because
“[e]quity’s vision is not circumscribed by formal instruments, but
extends through matters of form to the heart of the transaction.”34 They
rely on multiple factors to determine whether an equitable mortgage
exists; however, the principle element is whether the agreement creates
an underlying debt.35
Generally, the existence of an underlying debt is sufficient for
equitable courts to find that an equitable mortgage exists. If it is unclear
whether debt exists, courts consider less prominent factors, including:
(1) the relationship of the parties; (2) whether legal assistance was
available; (3) the sophistication and circumstances of each party; (4) the
adequacy of the consideration; (5) whether the borrower retained
possession of the property; (6) the statements of the parties; and (7)
whether the borrower acted as an owner (i.e., whether he paid property
taxes, made improvements, etc.).36 This is not an exhaustive list, but it
encompasses the majority of factors applied by courts of equity. Once a
court determines that a financing arrangement is an equitable mortgage
under these factors, it should ask whether the arrangement is a clog on
the equity of redemption.37
Over the centuries, ingenious mortgagees sought means to
minimize the protections of the equity of redemption. Once the equity
courts struck down the mortgagee’s waiver attempts, the mortgagees
turned to clauses that restricted the length of time a mortgagor had to
redeem.38 The courts of equity acted decisively to invalidate these
restrictions.39 Subsequently, the mortgagees attempted to use options,
which the mortgagee could exercise to take title to the real property if
the mortgagor defaulted.40 These actions were ruled as clogs for two
reasons: (1) the option allowed for the mortgagee to acquire title without
having to maintain a foreclosure action; and (2) the policy
considerations against permitting the use of options in this manner are so
strong, they are absolutely void and unenforceable, regardless of
whether actual oppression exists in the specific case.41 Similarly,
chancellors prohibited practices in which the mortgagor gave an
consider to determine whether an equitable mortgage exists); see also RESTATEMENT,
supra note 3, § 3.3(b)(1)-(7) (listing seven factors used to determine whether a contract
for deed is an equitable mortgage).
37. See Humble Oil, 303 A.2d at 905.
38. See Viverito, supra note 4, at 147 (citing generally the following cases where
time restrictions on mortgage redemption after default were held invalid: Frazer v.
Couthy Land Co., 149 A. 428 (Del. Ch. 1929) (three years); Bradley v. Davenport, 46
P. 1062 (Cal. 1896) (four months); Stover v. Bounds, 1 Ohio St. 107 (Ohio 1853)
(before a fixed date); and Floyer v. Lavington, 24 Eng. Rep. 384 (1714) (for the life of
39. See Frazer, 149 A. at 429 (invalidating the three-year time restriction for
redemption because “it appears to be settled that a right to redeem continues at all times
until it is foreclosed”); Bradley, 46 P. at 1065 (invalidating time limit by looking to the
circumstances surrounding the transaction); see also Stover, 1 Ohio St. at 110 (holding
that an assignee of the mortgage held an equitable claim to title of the land).
40. See Viverito, supra note 4, at 147; see also RESTATEMENT, supra note 3, at cmt.
b, illus. (providing several examples of clog and non-clog language).
41. Humble Oil, 303 A.2d at 906 (citing numerous sources concerning the history,
rationale and public policy behind options as clogs on the equity of redemption); see
also Samuel v. Jarrah Timber & Wood Paving Corp.,  A.C. 323 (H.L.) (affirming
that an option, even if fair and taken at an arms-length transaction, was invalid as an
impermissible clog); RESTATEMENT, supra note 3, § 3.1 cmt. d (noting that an overly
dogmatic approach to options should be avoided where the option is being used to clog
the mortgagor’s equitable right of redemption).
absolute deed to the mortgagee with the tacit understanding that the
mortgagee would only record the deed should the mortgagor default,
holding such practice to be an impermissible clog on the equity of
[The] maintenance [of the doctrine] is deemed essential to the
protection of the debtor, who, under pressing necessities, will submit
to ruinous conditions waiving the equity of redemption allowed him
or her on breach of his or her obligation, in the expectation and hope
of repaying the loan at the stipulated time and thus preventing
Two notable devices are critical to identifying clogs on the equity
of redemption. First, the installment land contract is a lending device
that makes time of the essence and the borrower’s (“vendee”)
acquisition of title conditional upon full satisfaction of the debt.44 In
some jurisdictions, these distinctions have been deemed sufficient to
remove these instruments from the mortgage protections and place them
within the scope of contract law.45 The installment land contract’s
forfeiture clause grants the vendor the power to cancel the contract,
retake possession of the real property, and claim the vendee’s payments
as liquidated damages.46 While the installment land contract may
initially appear to be clog on the equity of redemption, it serves a
valuable purpose within the housing market. Furthermore, many states’
equitable courts have held that the installment land contract, because it is
governed by contract law and not mortgage law, is not a clog.47 This
method of financing is exceedingly popular with low-income
mortgagors who may not otherwise satisfy the traditional mortgage’s
credit and down payment requirements.48 Lenders prefer this method in
states where judicial foreclosure sales are the only means of terminating
a mortgagor’s equity of redemption.49 However, a growing number of
jurisdictions and the Restatement view this arrangement as analogous to
an equitable mortgage, with all of its protections.50
The deed in lieu of foreclosure is the second notable lending
transaction not considered a clog on the equity of redemption51 because
it is given subsequent to the closing of the mortgage.52 A deed in lieu of
foreclosure terminates the mortgagor-mortgagee relationship after the
mortgagor defaults, but before the equity of redemption is foreclosed.53
The mortgagor conveys a deed to the mortgagee in return for the
mortgagee’s release of the mortgagor from the debt.54 As a result, the
defaulting mortgagor preserves his creditworthiness and avoids defense
costs in foreclosure and deficiency proceedings.55 Mortgagees seek
deeds in lieu of foreclosure to avoid the expense of initiating the
foreclosure proceedings.56 Courts closely scrutinize any subsequent
conveyance, however, to ensure that the transaction is adequately
supported by consideration and is free from fraud and oppression.57
The equity of redemption has endured as one of the major pillars of
mortgage law for over seven centuries. While mortgagees have striven
to nullify its protections, the courts of equity have guarded this right
faithfully. The doctrine reflects the equitable courts’ understanding of
the disparity in the parties’ bargaining positions and attempts to inject a
basic level of fairness into the stream of housing commerce.
49. See RESTATEMENT, supra note 3, § 3.4 cmt. a.
50. See id. § 3.4 cmt. b (“Some view this right as an unconditional and the
equivalent of the mortgagor’s equity of redemption, while others condition the right on
the purchaser’s prior payments having been sufficient to create a substantial equity in
the property,” with the purchaser’s ability to redeem dependent upon whether the
payments already made exceed the fair rental value of the real estate. Those guilty of
gross negligence or bad faith may be barred from redemption).
51. See generally DUKEMENIER & KRIER, supra note 2.
52. See RESTATEMENT, supra note 3, at cmt. f; see also John C. Murray, Clogging
Revisited, 33 REAL PROP. PROB. & TR. J. 279, 287-89 (1998-1999).
53. See Murray, supra note 52.
56. Id. at 287.
57. Id. at 288.
II. ISLAM AND INTEREST
Home ownership remains elusive for many Muslims because Islam
forbids its followers from either paying or receiving interest. This
prohibition arose during the early years of the Prophet Mohammed’s
teaching when usurious loans were rampant and the failure to repay a
debt often resulted in slavery.58 “By outlawing interest, Islam advocated
an economy based on risk-sharing, fair dealing, and equity – in both the
financial and social – justice senses of the word.”59 The Qur’an clearly
and simply warns its followers that “God has forbidden riba.”60 While
the Qur’an does not expressly define riba, the Sunna, which is the
second most influential religious authority,61 states that “[e]very loan
that attracts a benefit is riba.”62 Therefore, devout Muslims are unable
to obtain traditional interest-bearing loans to purchase homes and must
instead rely upon savings or non-interest loans from friends and
Considering that the average price of homes in 2006 was
approximately $169,000,63 the non-financing home buyer must sacrifice
years of equity-building in order to save a sufficient amount to purchase
property outright. Furthermore, the non-home owner loses not only tax
benefits,64 but also familial and societal advantages.65 The
Homeownership Alliance asserts essentially four primary social benefits
to homeownership: (1) advantages to children, including higher
academic performance and lower instances of behavioral problems; (2)
higher civic participation; (3) greater overall health and happiness; and
(4) enhanced property values.66 Muslims who cannot raise sufficient
resources to purchase a home outright are forced to choose between
rejecting piety or sacrificing the benefits of home ownership. Therefore,
many Muslims are losing out on a critical aspect of the American dream.
In response to the religious barriers to home ownership for
Muslims, lending institutions have begun seeking ways to meet the
needs of this expanding community.67 There are many variations of
alternative lending methods; this Article analyzes two proposals
submitted to the Office of the Comptroller of the Currency (“OCC”),
representing the basic arrangements available.68
A. The United Bank of Kuwait’s Net Lease Proposal
The United Bank of Kuwait (“UBK”) brought the first proposal for
Islamic-centered mortgage alternatives to the OCC in 1997.69 UBK
wished “to offer Net Leases to meet the special needs of its customers
who adhere to the principles of Islam.”70 Under the UBK Net Lease
program, the lessee will select a home and agree to a purchase price with
the seller.71 Next, the lessee will enter into a Net Lease Agreement and
a Purchase Agreement (collectively “the Agreements”) where the lender
will agree to purchase the home and serve as landlord, and the lessee
will make a monthly payment which will comprise principal, rent, taxes,
and insurance components.72 UBK will add its cost of funds, as
determined by the London Interbank Offering Rate (“LIBOR”), at the
start of the lease.73 While UBK will retain legal title, the lessee shall
have the right of possession to the home for a specified number of
years.74 The lessee will be responsible for maintaining the property and
paying the expenses normally associated with purchaser’s
responsibilities.75 Under the payment terms, the principal amount will
amortize over the term of the lease.76 Once the principal sum is fully
amortized, UBK will transfer title to the home to the lessee
The Agreements also permit the lessee to prepay the principal and
acquire title to the property early.78 In the event that the lessee
materially defaults under the Agreements, UBK will have remedies
similar to those under a traditional mortgage.79 UBK will provide notice
to the lessee of default and allow a period to cure the default;80 however,
if the lessee fails to cure within that time frame, UBK will terminate the
lease and treat the property as if it had been acquired in foreclosure.81
In advocating its proposal, UBK argued that the transaction would
be functionally equivalent in economic substance to a secured real
property transaction.82 To support its argument that the transaction
would be functionally equivalent to traditional real estate financing,
UBK intended to carry the loans on its financial records as financing,
rather than leasing, in accordance with Generally Accepted Accounting
Principles (“GAAP”).83 Furthermore, UBK anticipated that the Internal
Revenue Service would treat the transaction as a financing agreement,
allowing the lessee to deduct the imputed interest portion of the lease
payment on their tax filings.84 Essentially, for accounting and tax
purposes UBK would treat the transaction as a traditional
interestbearing loan, but the Islamic lessee would regard the transaction as a
non-interest-bearing lease-to-own agreement, while also receiving the
advantages of home ownership.85
In analyzing whether UBK’s proposal was appropriate under the
current regulatory scheme, the OCC turned to the National Banking Act
(“Bank Act”),86 which authorizes the OCC to regulate domestic
branches of foreign banks and enumerates the following powers of
[t]o exercise . . . all such incidental powers as shall be necessary to
carry on the business of banking; by discounting and negotiating
promissory notes, . . . and other evidence of debt; by receiving
deposits; by buying and selling exchange, coin, and bullion; by
loaning money on personal security; and by obtaining, issuing, and
circulating notes . . . (emphasis added).87
In NationsBank of North Carolina, N.A. v. Variable Life Annuity
Insurance Co., the U.S. Supreme Court broadly interpreted the “business
of banking” to extend beyond these powers88 and added that the OCC
has discretion to “authorize activities beyond those specifically
enumerated.”89 In determining whether a proposed activity is within the
“business of banking,” the OCC relies upon three general principles: (1)
whether the proposal is “functionally equivalent” or logically follows an
approved activity;90 (2) whether the proposal is responsive and/or
beneficial to the bank’s customers;91 and (3) whether the bank is
assuming new risks.92
In adhering to these statutory and judicial mandates, the OCC
concluded that the proposal fell within the ambit of the Bank Act
because it was “functionally equivalent to or a logical outgrowth of
secured lending.”93 After examining the actual accounting, regulatory,
and tax effects of the proposed transaction the OCC opined that:
UBK’s Net Lease proposal responds to the special issues regarding
Islamic customers by providing an alternative method for a discrete
group to get access to credit without forcing them to choose between
their religion and home ownership. It allows followers of Islam to
purchase homes without violating Islamic proscriptions on
borrowing money on which interest is charged. Furthermore, UBK’s
Net Lease proposal is consistent with the well-established public
policy of encouraging home ownership.94
In approving UBK’s proposal, the OCC opened the door for Islamic
mortgagors to remain true to their religious tenets while simultaneously
enjoying the benefits of homeownership.
B. UBK’s Net Lease Proposal Is a Clog of the Mortgagor’s
Equity of Redemption
Two years later, the OCC reaffirmed its commitment to lending
flexibility when it approved a second lending institution’s proposal to
offer murabaha financing products.95 Murabaha is akin to a
cost-plusprofit financing arrangement where the lender essentially functions as a
“riskless principal,” or quasi-agent.96 Here, the lender purchases the
home on behalf of the borrower and then resells the home to the
M & M Leasing Corp. v. Seattle First Nat’l Bank, 563 F.2d 1377 (9th Cir. 1977).
91. See Interpretive Letter No. 806, supra note 69, at 9.
92. Id.; see, e.g., Merchants’ Nat’l Bank, 77 U.S. 604 (1871); Am. Ins. Ass’n, 865
F.2d 278 (2nd Cir. 1988); M & M Leasing Corp., 563 F.2d 1377 (9th Cir. 1977).
93. See Interpretive Letter No. 806, supra note 69, at 4.
94. Id. at 9.
95. Interpretive Letter No. 867, [1999-2000 Transfer Binder] Fed. Banking L. Rep.
(CCH) ¶ 81,361
(Off. of the Comptroller of the Currency June 1, 1999)
Interpretive Letter No. 867], available at http://www.occ.treas.gov/interp/nov99/int86
7.pdf (pagination, infra, consistent with URL source) (agreeing that murabaha
financing transactions are permissible).
96. Id. at 1.
borrower at an agreed upon profit. Under the terms of the agreement,
the borrower remits a down payment to the lender, which is not to
exceed 25%, and finances the difference.97 Using a recognized market
index, such as LIBOR, the lender determines the profit by calculating
the present value of the interest payments, like a traditional
interestbearing mortgage, and adds that amount to the debt. 98 The borrower
makes equal installment payments based on the cost-plus-profit amount
until the debt is fully amortized.99
Once the closing has occurred the lender records the title with a
senior mortgage (or deed of trust) on the property.100 In the event the
borrower defaults under the murabaha contract, the lender may
foreclose on the real property as it would under a traditional real estate
transaction.101 In addition to the foreclosure, the lender may seek a
judgment for any deficiency between the balance due and the contract
The OCC determined that the murabaha proposal was functionally
equivalent to conventional financing transactions and approved the
proposal, as it had the Net Lease proposal.103 Based largely on its earlier
decision in favor of UBK,104 the OCC found that the murabaha
transaction would be treated as a secured lending transaction for
accounting, regulatory, and tax purposes and was within the scope of the
approved policies of the Bank Act.105
C. Criticisms of the Islamic Mortgage Alternatives
Even though the OCC, banks, and a growing number of consumers
embrace the Net Lease and murabaha, these mortgage alternatives are
not without their critics. Some argue that “the ‘Islamic Bank’ is a
Trojan horse which has been infiltrated into Dar al-Islam106. . . . [It] is a
totally crypto-usurious institution and like all other usurious institutions
must be rejected and fought.”107 On their faces, the Net Lease and
murabaha appear to be interest-free financing products; however, some
strict interpreters argue that “the ‘fees,’ ‘mark-ups,’ and ‘profit-sharing’
of Islamic transactions are a thinly veiled subterfuge for interest.”108
The assertions that these mortgage alternatives are merely “thinly
veiled” interest transactions are concededly valid, and supported by
traditional notions and understandings of economic thought. Interest is
essentially the cost applied for borrowing money.109 The Net Lease
veils its interest charge in the term “rent,”110 whereas the murabaha
similarly disguises its interest in the profit tacked on to the principal
amount at the start of the relationship.111 Without these two components
of the payment, however, the lenders would fail to realize a profit on the
transaction and would be unwilling to lend money. While the arguments
for and against Islamic mortgage alternatives are cogent, whether an
interpretation is correct is a question of one’s faith and is beyond the
scope of this inquiry.
III. RECONCILING ISLAMIC MORTGAGE ALTERNATIVES WITH THE
EQUITABLE RIGHT OF REDEMPTION
While the OCC’s imprimatur went a long way in helping Muslims
obtain flexible financing methods, neither it nor the proposing banks
addressed what effect these proposals would have on the equity of
redemption. One fundamental objective of the equity of redemption is
to protect the mortgagor from the superior bargaining power of the
mortgagee.112 This basic concern is even more apposite when
mortgagees replace traditional mortgages—and their strong common
law protections—with novel alternatives marketed toward a specific
class of borrowers.
A. The Net Lease and Murabaha Are Equitable Mortgages
To determine whether these proposals satisfy this basic concern,
this Article analyzes the Net Lease and the murabaha using the same
factors that courts of equity apply in deciding whether a particular
financing arrangement is an equitable mortgage.113 Based on the
information provided within the OCC’s interpretative letters, the Net
Lease and the murabaha proposal should be treated as equitable
mortgages because the underlying substance of each transaction is a debt
secured with real property.114 Both agreements create an obligation for
the borrower, and if the borrower defaults, the lender can seize the home
to recover the loaned amount.115 Furthermore, the lender records the
transaction in conformity with GAAP, as a traditional mortgagee would,
and reports the earnings as interest income for tax purposes,116 giving
credence to the contention that these transactions are mortgages.
Moreover, UBK and the proposing lender in Interpretative Letter No.
867 argued that the borrowers will be able to deduct some portion of
their payments as interest, as traditional mortgagors are entitled to do.117
Thus, both the Net Lease and the murabaha create a
mortgagormortgagee relationship in which an underlying debt exists.
In both the Net Lease and murabaha, the borrower retains
possession, unless and until he defaults and the mortgagee forecloses.118
Under both proposals, the borrower acts as a traditional mortgagor, with
responsibility for the utilities, homeowner’s insurance, property taxes,
repairs and renovations.119 Furthermore, the borrower may improve the
property, repay the debt early, and sell the property.120 The proposing
lenders, like traditional lenders, cannot regain possession of the property
until the borrower’s interest has been foreclosed, either by the expiration
of the redemption period in the Net Lease or by way of judicial
foreclosure in the murabaha. Lastly, the most telling similarity between
the Net Lease and murabaha borrowers and traditional mortgagors is
that the Net Lease and murabaha borrowers pay a premium for the use
of another’s capital, just like traditional interest-paying mortgagors.
The installment land contract, which the Restatement considers to
be a mortgage,121 can be analogized to the Net Lease. Under the
Restatement definition, an installment land contract—also referred to as
a contract for deed—entitles a purchaser to possession of the fee, but
conditions the vendor’s delivery of title on the successful performance
of the agreement.122 UBK’s proposal achieves substantially the same
outcome as an installment land contract because UBK retains title to the
encumbered property until the borrower repays the debt.123
Furthermore, UBK’s proposal allows it to unilaterally determine
whether the borrower has defaulted on the note; it may thus regain
possession to the property without foreclosing the borrower’s equity of
redemption. In light of the Restatement, therefore, the Net Lease is a
veritable installment land contract.
Although the ‘installment land contract’ label fits the Net Lease, the
chancellors cannot attach the same appellation to the murabaha. By
contrast, the murabaha proposal expressly states that the lender does not
retain possession of the title; instead, the lender records the title in the
name of the borrower and lists himself as holding a first mortgage.124
Under the facts presented to the OCC, the vendor does not defer delivery
until the successful satisfaction of the underlying debt125 and, therefore,
120. See Interpretive Letter No. 806, supra note 69, at 2; Interpretive Letter No. 867,
supra note 95, at 4.
121. See RESTATEMENT, supra note 3, § 3.4 (b). This alternative approach assumes
the state in which the transaction occurs has adopted the Restatement’s treatment of
installment land contracts.
122. See id.
123. See supra Part III.A; Interpretive Letter No. 806, supra note 69, at 2.
124. Interpretive Letter No. 867, supra note 95, at 4.
125. Cf. id. Note, the Interpretive Letter does not expressly say the delivery would
not be delayed until full satisfaction of the debt. The closest inference is that the
proposal largely resembles a conventional mortgage. See id.
the equity courts should not designate murabaha as installment land
Clearly, any examination of the Net Lease or murabaha shows that
these arrangements are tantamount to mortgages. Accordingly, these
borrowers ought to be entitled to the same protections as traditional
mortgagors, including the equitable right of redemption. The court of
equity’s next step is to determine whether either of the proposed
financing arrangements are clogs on the equity of redemption. 126
B. UBK’s Net Lease Proposal May Clog the Mortgagor’s
Equity of Redemption
UBK’s Net Lease is an impermissible clog on the equity of
redemption in non-strict foreclosure states. Under the Net Lease
Agreement, the lessee has a specific time frame to cure the default and,
in the event the default is not cured, UBK may unilaterally treat the
home as if acquired in foreclosure.127 This situation is analogous to
Illustration 2 of Section 3.1 of the Restatement (Third) of Property:
“Mortgagor agrees that her right to redeem under this mortgage shall
terminate four months after mortgagee declares a default under this
mortgage.”128 In the UBK Net Lease, the lessee loses his right to
redeem after a stated period of time without the benefit of a
foreclosure.129 Therefore, the Net Lease is an impermissible clog on the
borrower’s equity of redemption.
Interestingly, there is a variation of UBK’s Net Lease circulating in
the market called an ijara wa-iqtina. The ijara wa-iqtina is similar in all
discernible respects to the Net Lease except that the borrower has an
option to purchase the home at the end of the lease term.130 At first
glance the existence of the option does not exacerbate the clog problem,
because it is the mortgagor—and not the mortgagee—who has the
option to purchase the land. Moreover, if the roles were reversed, the
transaction would clearly be an example of a clog, since the mortgagor
126. The following arguments assume that the assumption that the Net Lease and
murabaha should be treated as equitable mortgages.
127. See Interpretive Letter No. 806, supra note 69, at 2.
128. See RESTATEMENT, supra note 3, at cmt. b, illus. 2.
129. See Interpretive Letter No. 806, supra note 69, at 2.
130. See Knoll, supra note 61, at 16 (citing Tarek Zaher & Kabir Hassan, A
Comparative Literature Survey of Islamic Finance, in 5 FINANCIAL MARKETS,
INSTITUTIONS & INSTRUMENTS 155, 160 (2001)).
would convey the option contemporaneously with the mortgage.131 This
Net Lease-variant is not necessarily acceptable because the ijara
waiqtina turns the option on its head, however. In order to be valid, an
option must have independent consideration;132 here, the mortgagee is
essentially charging a fee for the mortgagor to have the right to redeem
his property at the end of the lease period. With the exception of the
mortgagor’s option, the ijara wa-iqtina is the same as the Net Lease and
should be treated accordingly as an equitable mortgage. Since the equity
of redemption is a fundamental right of the mortgagor and zealously
guarded by the equitable courts,133 the mortgagor should not be required
to pay an additional sum for that right. By requiring an additional step
of exercising the option for the mortgagor to redeem the property, the
mortgagee has created an impermissible clog on the equity of
redemption. Accordingly, the equity courts should invalidate the option.
C. The Murabaha is Not a Clog on the Equity of Redemption
In contrast with the Net Lease, the murabaha is not a clog on the
equity of redemption because the lender is not entitled to take possession
of the home until the equity court has foreclosed the borrower’s right to
redeem. The murabaha borrower enjoys the same property rights and
responsibilities as traditional mortgagors.134 Unlike in Net Lease
transactions, the murabaha lender does not retain legal title to the land,
but rather records the title in the land records in the name of the
borrower, while listing itself as holding a first mortgage.135 If the
borrower defaults under the murabaha, the lender cannot reenter the
property until it provides notice of default and then forecloses the equity
of redemption period, either through a trustee’s or sheriff’s sale.136
The most significant difference between the murabaha and Net
Lease lender is that the murabaha lender cannot act unilaterally in
determining when it may regain possession of the mortgaged property.
Thus, in all material respects the murabaha confers the same bundle of
property rights as traditional mortgages and is functionally and legally
equivalent to an equitable mortgage. As such, the mortgage alternative
proposed in Interpretive Letter No. 867 adequately protects the
mortgagor’s equitable right to redeem the property.
IV. AMELIORATING THE OBSTACLES PRESENTED BY THE NET LEASE
The potential danger of relinquishing common law rights is not
limited to the specific instances of UBK’s Net Lease or Islamic
borrowers, but rather extends to all borrowers who might be attracted to
“religious friendly” mortgage alternatives. A nefarious lender could
peddle fallacious arrangements to low-income, unsophisticated, and
divinely obedient borrowers—whether Muslim or not—in the hope that
they would be unaware of the protections bestowed on them by the
common law. There should be greater concern that, under the pretense
of religious flexibility, inimical lenders could seek to manipulate pious
borrowers out of their equity of redemption or disguise higher interest
rates as “rent” or “mark up profit.”
A. Saving the Net Lease Proposal Through Contract Rights
The fact that the Net Lease might serve as a clog on the equity of
redemption should not be fatal to its enforceability. The Net Lease can
be saved by reforming the default provision to state explicitly that the
lessee has the right to redeem the property at any time before a judicial
foreclosure. While it could be costly and inconvenient for UBK and
other lenders to seek a judicial foreclosure, that path may ultimately
prove less costly than litigating claims asserting a clog on the lessee’s
equitable right of redemption. Given the close judicial scrutiny of
arrangements claiming to not be mortgages, the assertion that the Net
Lease is not a mortgage might fall on deaf ears.
B. Adding Clarity and Finality to the Murabaha
While the murabaha is not a clog, it is not without its shortcomings.
The OCC proposal is unclear as to what amount a mortgagor will have
to pay to redeem his property from default.137 Since the interest is
tacked on to the principal amount at the start of the loan,138 will the
137. Cf. Interpretive Letter No. 867, supra note 95, at 2-4.
138. Cf. Interpretive Letter No. 867, supra note 95, at 3 (stating that the murabaha
profit is typically based on a recognized interest rate index, e.g., LIBOR).
murabaha mortgagor have to pay the entire remaining principal amount
in the event of a default? If this is the case, he will be paying more than
a traditional mortgagor who is only required to pay the amount of
principal and accrued interest due at the time of default. In other words,
the murabaha borrower will essentially be paying a substantial premium
to redeem his property. Consequently, the murabaha changes into a
partial clog and the borrower will receive a worse deal than a traditional
mortgagor. Furthermore, if the murabaha borrower must pay the entire
cost-plus-profit amount, the lender will receive a substantial windfall
which has yet to accrue under traditional accounting and economic
The price of piety should not require religious mortgagors to pay
substantially more than secular mortgagors. The murabaha’s
shortcomings may be corrected by attaching a schedule to the agreement
that illustrates what amount would be necessary to cure a default at any
given installment. It could be based on a simple amortizing schedule
that would reflect the interest earned as of the date of default. The
schedule adds finality to the agreement, provides the mortgagee with an
equitable amount of interest, and relieves the mortgagor from
shouldering a higher burden than a traditional curing mortgagor.
Alternatively, the murabaha contract language could devise a formula
that serves essentially the same purpose as the schedule to avoid the
specter of interest. The notion that a defaulting Islamic mortgagor
should have to pay more than a traditional mortgagor to redeem his
property because of religious adherence is untenable in a nation that
prides itself on free exercise of religion.
This Article set out to explore whether it is possible for an
expanding segment of the population to remain true to their religious
beliefs while living the American dream. By examining the historical
aspects and rationales underlying one of the longest-standing pillars of
mortgage law, this Article sought to address a subtle yet monumentally
important concern with a relatively new financing vehicle. While the
proposals submitted to the OCC do not perfectly meet the rigors of
common law mortgage protections, courts of equity and regulators
should embrace these Islamic-centered mortgage alternatives in order to
encourage home ownership and maintain flexibility within the home
financing market. Furthermore, the existing imperfections can be cured
31. Humble Oil & Ref. Co. v. Doerr, 303 A.2d 898 , 905 (N.J. Super . Ct. Ch. Div. 1973 ) ; accord Cousins v . Crawford, 63 So. 2d 670 (Ala . 1953 ); Bergerding Inv . Co. v. Larson, 170 N.W.2d 322 , 326 (Minn. 1969 ); Rice v . Wood , 346 S.E.2d 205 , 211 (N.C. Ct . App. 1986 ); Conley v . Henderson , 75 P.2d 746 , 750 (Or. 1938 ); Odenbaugh v . Bradford , 67 Pa. 96 , 96 (Pa. 1870 ); Holmes v . Basham , 45 S.E.2d 252 , 256 ( W. Va . 1947 ).
32. See generally Humble Oil, 303 A.2d at 905 (establishing a general trend of applying a two-step analysis).
33. See id.
34. See Bergerding Inv. Co., 170 N.W.2d at 326.
35. Grant v. Pattison , 371 P.2d 870 , 873 (Mont. 1962 ) (citing 1 JONES ON MORTGAGES § 316 , p. 386 - 87 (5th ed. 1894 ) (explaining “the existence of the debt is the test”); see also Flack v . McClure , 565 N.E.2d 131 , 136 (Ill. App. Ct. 1990 ) (noting the existence of a debt as the “essential element” in determining whether an equitable mortgage exists).
36. See Flack, 565 N.E. 2d at 136 (listing six factors that trial courts should
42. See , e.g., Smith v . Headlee , 183 P. 20 ( Or . 1919 ) ; see also RESTATEMENT, supra note 3 .
43. Smith , 183 P. 20 at 22.
44. GRANT S. NELSON & DALE A. WHITMAN, REAL ESTATE TRANSFER , FINANCE, & DEVELOPMENT 284 ( 2003 ); see also Frank R. Lacy, Land Sale Contracts in Bankruptcy, 21 U.C.L.A. L. REV . 477 ( 1973 ) (stating that “resort to the installment contract device is usually attributed to the unavailability of mortgage financing for very low down payment sales and to the supposed ease of terminating the purchaser's interest in the property in the event of default”).
45. See RESTATEMENT , supra note 3, § 3 . 4 cmt. a; see also Roger A. Cunningham & Saul Tischler, Disguised Real Estate Security Transactions As Mortgages in Substance, 26 RUTGERS L . REV. 1 , 7 ( 1972 - 73 ).
46. See RESTATEMENT , supra note 3, § 3.4 cmt. a.
47. See Cunningham & Tischler, supra note 45, at 7.
58. Jerry Useem , Banking on Allah: Devout Muslims Don't Pay or Receive Interest. So How Can Their Financial System Work? , FORTUNE, June 10, 2002 , at 145.
59. Id .
60. Qur'an 2 : 275 .
61. Michael Knoll , The Ancient Roots of Modern Financial Innovation: The Early History of Regulatory Arbitrage 13 (U . Pa. Law Sch., Scholarship at Penn Law, Paper No. 49 , 2004 ), available at http://lsr.nellco.org/upenn/wps/papers/49.
62. Id . (referring to the passage of the Sunna that most clearly states the definition of riba).
63. U.S. CENSUS BUREAU , HOUSING AND HOUSEHOLD ECON . STATISTICS DIV., CURRENT POPULATION SURVEY/HOUSING VACANCY SURVEY, TBL . 11A ( 2008 ), available at http://www.census.gov/hhes/www/housing/hvs/historic/histt11.html.
64. I.R.C. § 163 (a) ( 2006 ) (allowing home owners to deduct interest from their adjusted gross income).
65. ROBERT D. DIETZ , HOMEOWNERSHIP ALLIANCE , THE SOCIAL CONSEQUENCES OF HOMEOWNERSHIP 3 ( 2003 ), available at http://www.newtowncdc.org/pdf/social_conseq uences_study.pdf.
66. See id. at 13.
67. While this article will focus on the United Bank of Kuwait's Net Lease Proposal in Interpretive Letter No. 806 and the murabaha proposed in Interpretive Letter No. 867, these are not the only lenders providing alternative mortgages to Muslims. For a discussion of alternate lending methods, see Bill Maurer, Articulating Islamic Knowledge to an American Dream: Islamic Home Financing Alternatives After September 11 , 2001 , 26 POL. & LEGAL ANTHROPOL. REV . 196 ( 2003 ).
68. Off. of the Comptroller of the Currency, About the OCC , http://www.occ.gov/aboutocc. htm (last visited Jan . 28 , 2008 ). The OCC charters, regulates, and supervises all national banks and all federal branches of foreign banking institutions . Id.
69. Interpretive Letter No. 806 , [ 1997 -1998 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 81 , 253 (Off. of the Comptroller of the Currency Oct . 17 , 1997 ) [hereinafter Interpretive Letter No. 806 ], available at http://www.occ.treas.gov/interp/dec97/int80 6. pdf (pagination, infra, consistent with URL source) .
70. Id . at 1.
71. Id .
72. Id .
73. Id . at 2.
74. Id .
75. Id .
76. Id .
77. Id . The Interpretive Letter is silent as to how UBK will transfer title or when it would deliver the deed to the lessee . See id.
78. Id .
79. Id .
80. Id .
81. Id .
82. See id.
83. Id . at 1 -2; see also INCEPTION OF THE LEASE , Statement of Fin . Accounting Standards No. 23 ( Fin. Accounting Standards Bd . 1978 ), http://www.fasb.org/pdf/fas2 3. pdf (discussing the generally accepted accounting principles for leases); ACCOUNTING FOR LEASES, Statement of Fin . Accounting Standards No. 98 ( Fin. Accounting Standards Bd . 1988 ), http://www.fasb.org/pdf/fas98.pdf.
84. See Interpretive Letter No. 806 , supra note 69, at 3; see also I.R.C. § 7701 (l) ( 2006 ) (authorizing the Secretary of the Treasury to “prescribe regulations recharacterizing any multiple-party financing transaction as a transaction directly among any two or more of such parties where the Secretary determines that such recharacterization is appropriate to prevent avoidance of any tax imposed by this title”); I .R.C §§ 1271 - 1276 ( 2006 ) (discussing imputed interest for debt instruments ).
85. See generally Interpretive Letter No. 806 , supra note 69.
86. National Banking Act, 12 U.S.C. §§ 24 (Seventh), 371 ( 2006 ).
87. See Interpretive Letter No. 806 , supra note 69, at 3 (quoting the Bank Act) .
88. NationsBank of N.C., N.A. v. Variable Life Annuity Ins . Co., 513 U.S. 251 , 258 ( 1995 ).
89. Id . at 258, n. 2.
90. Interpretive Letter No. 806 , supra note 69, at 4; see, e.g., Merchants' Bank v. State Bank , 77 U.S. 604 ( 1871 ) ; Am. Ins. Ass'n v . Clarke , 865 F.2d 278 ( 2d Cir . 1988 ); 106 . MARSHALL G. S. HODGSON, THE VENTURE OF ISLAM, CONSCIENCE AND HISTORY IN A WORLD CIVILIZATION I: THE CLASSICAL AGE OF ISLAM 513 ( 1974 ). “ Dar al-Islam: lands under Muslim rule . . . converse of Dar al-Harb, i.e., lands under nonMuslim rule .” Id.
107. Umar Ibrahim Vadillo , The Fallacy of the “Islamic Bank ,” http://www.geocities.com/Athens/Delphi/6588/bfallacy. html (last visited Jan . 30 , 2008 ).
108. Marla Dickerson , The Price of Piety in Islam, L.A. TIMES , Mar. 17 , 1999 , at A1.
109. See Economics A-Z: Interest , Economist.com, http://www.economist.com/resea rch/Economics/searchActionTerms.cfm ?query=interest (last visited Jan . 30 , 2008 ).
110. See Interpretive Letter No. 806 , supra note 69, at 8.
111. See Interpretive Letter No. 867 , supra note 95, at 1.
112. Viverito , supra note 4, at 146-47.
113. See supra Part I.
114. See supra Part II.A-B.
115. See Interpretive Letter No. 806 , supra note 69, at 2; Interpretive Letter No. 867 , supra note 95, at 5.
116. See Interpretive Letter No. 806 , supra note 69, at 9; Interpretive Letter No. 867 , supra note 95, at 6.
117. See Interpretive Letter No. 867 , supra note 95, at 6.
118. Cf . Interpretive Letter No. 806 , supra note 95, at 2; Interpretive Letter No. 867 , supra note 95, at 5.
119. Cf . Interpretive Letter No. 806 , supra note 69, at 2; Interpretive Letter No. 867 , supra note 95, at 4.